The First Global Financial Crisis of the 21st Century A VoxEU.org Publication Centre for Economic Policy Research (CEPR) Centre for Economic Policy Research 53-56 Great Sutton Street London EC1V 0DG UK Tel: +44 (0)20 7183 8801 Fax: +44 (0)20 7183 8820 Email: cepr@cepr.org Website: www.cepr.org © June 2008 Centre for Economic Policy Research British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN: 978-0-9557009-3-4 The First Global Financial Crisis of the 21st Century A VoxEU.org Publication Edited by Andrew Felton and Carmen Reinhart Centre for Economic Policy Research (CEPR) The Centre for Economic Policy Research is a network of over 700 Research Fellows and Affiliates, based primarily in European universities The Centre coordinates the research activities of its Fellows and Affiliates and communicates the results to the public and private sectors CEPR is an entrepreneur, developing research initiatives with the producers, consumers and sponsors of research Established in 1983, CEPR is a European economics research organization with uniquely wide-ranging scope and activities The Centre is pluralist and non-partisan, bringing economic research to bear on the analysis of medium- and long-run policy questions CEPR research may include views on policy, but the Executive Committee of the Centre does not give prior review to its publications, and the Centre takes no institutional policy positions The opinions expressed in this report are those of the authors and not those of the Centre for Economic Policy Research CEPR is a registered charity (No 287287) and a company limited by guarantee and registered in England (No 1727026) Chair of the Board President Chief Executive Officer Research Director Policy Director Guillermo de la Dehesa Richard Portes Stephen Yeo Mathias Dewatripont Richard Baldwin Contents Preface Introduction ix Section Why Did the Crisis Happen? The relationship between the recent boom and the current delinquencies in subprime mortgages Giovanni Dell’Ariccia, Deniz Igan and Luc Laeven Why bank risk models failed Avinash Persaud 11 Blame the models Jon Danielsson 13 The subprime crisis: observations on the emerging debate Charles Wyplosz 17 The subprime series, part 1: Financial crises are not going away Stephen G Cecchetti 21 The subprime series, part 2: Deposit insurance and the lender of last resort Stephen G Cecchetti 25 The subprime series, part 3: Why central banks should be financial supervisors Stephen G Cecchetti 29 The subprime series, part 4: Does well-designed monetary policy encourage risk- taking? Stephen G Cecchetti 33 The subprime crisis: Greenspan’s Legacy Tito Boeri and Luigi Guiso 37 The impact of short-term interest rates on risk-taking: hard evidence Vasso P Ioannidou, Steven Ongena and Jose Luis Peydró 41 Why did bank supervision fail? Guido Tabellini 45 vi The First Global Financial Crisis of the 21st Century The subprime crisis and credit risk transfer: something amiss Luigi Spaventa 49 The crisis of 2007: some lessons from history Michael D Bordo 51 Reflections on the international dimensions and policy lessons of the US subprime crisis Carmen Reinhart 55 Section How Is the Crisis Unfolding? 61 Federal Reserve policy actions in August 2007: frequently asked questions (updated) Stephen G Cecchetti 63 An extensive but benign crisis? Tommaso Monacelli 73 Not (yet) a ‘Minsky moment’ Charles W Calomiris 77 A B & B future for subprime borrowers? Willem Buiter 85 Double counting 101: the useful distinction between inside and outside assets Willem Buiter 91 Bagehot, central banking and the financial crisis X Vives 99 The financial crisis: why it may last Angel Ubide 103 Fallout from the credit crunch Dennis J Snower 107 Four mega-dangers international financial markets face Dennis J Snower 109 Federal Reserve policy responses to the crisis of 2007–8: a summary Stephen G Cecchetti 113 While the ECB ponders, the Fed moves – and cleverly at that Charles Wyplosz 117 Contents vii Section What Can Be Done? 119 The subprime crisis: Who pays and what needs fixing Marco Onado 121 Filling the information gap Alberto Giovannini and Luigi Spaventa 125 Lessons from the North Atlantic financial crisis Willem Buiter 129 Lessons from Northern Rock: banking and shadow banking Willem Buiter 133 Lessons from Northern Rock: how to handle failure Willem Buiter 137 Ratings agency reform Richard Portes 145 How to avoid further credit and liquidity confidence crises Guillermo de la Dehesa 151 The inappropriateness of financial regulation Avinash Persaud 155 There is more to central banking than inflation targeting Paul De Grauwe 159 Can monetary policy really be used to stabilize asset prices? 163 Katrin Assenmacher-Wesche and Stefan Gerlach A missed opportunity for the Fed Willem Buiter and Anne Sibert 167 The central bank as the market-maker of last resort: from lender of last resort to market-maker of last resort Willem Buiter and Anne Sibert 171 Avoiding disorderly deleveraging Luigi Spaventa 179 Chronology Glossary 183 191 Preface This book is a selection of VoxEU.org columns that deal with the subprime crisis VoxEU.org is a portal for research-based policy analysis and commentary written by leading economists It was launched in June 2007 with the aim of enriching the economic policy debate by making it easier for serious researchers to contribute and to make their contributions more accessible to the public The subprime crisis, which boiled over in August 2007, was the perfect showcase for Vox’s unique approach Mainstream media’s explanations of it as a liquidity crisis did not seem to fit the facts How could a few deadbeat homeowners in the United States bring down a German Landesbank, force a restructuring on a major French bank, and compel the Fed and the European Central Bank (ECB) to undertake emergency injections of cash? The story was surely deeper than a standard-issue credit problem Starting on 13 August 2007, Vox posted a slew of columns by economists who really knew what they were talking about and were willing to explain the crisis in terms that any trained economist could understand Mainstream media’s limits (800 words written for the average newspaper reader) just did not work for an event of this complexity Vox provided commentators with the space to explain the situation using standard economic terminology It raised the level of the public debate and this attracted researchers who had also been at the cutting edge of policy-making, such as: Willem Buiter (professor at LSE and former member of the Bank of England’s rate-setting Monetary Policy Committee), Steve Cecchetti (professor at Brandeis University and former Executive Vice President and Director of Research at the New York Fed), Charles Wyplosz (professor at the Graduate Institute, Geneva and adviser to central banks), Marco Onado (professor at Bocconi and former Commissioner of the Italian public authority responsible for regulating the Italian securities market, CONSOB), Tito Boeri (professor at Bocconi and editor of LaVoce) and Luigi Spaventa (professor in Rome and former Chairman of CONSOB) On behalf of CEPR and the Vox editorial board, I would like to thank Carmen Reinhart for agreeing to edit this compilation of columns Together with her colleague at the University of Maryland’s School of Public Policy, Andrew Felton, the result is what follows, a primer on what is probably the worst financial crisis of our generation Richard Baldwin, VoxEU.org, Editor-in-Chief and CEPR Policy Director June 2008 ix 180 The First Global Financial Crisis of the 21st Century Forced deleveraging and the liquidity spiral The immediate problem is the disorderly reaction to the unprecedented growth of the financial system’s leverage and its exposure to risk As demand for asset-backed securities has disappeared, prices have collapsed without finding a floor Banks are reporting losses that strain their capital positions The loss of market liquidity affecting all classes of debt securities directly or indirectly owned by intermediaries has translated into a sharp decline of funding liquidity, the more so because shortterm debt issued on wholesale markets has become a major component of banks’ funding The forced adjustment of banks’ balance sheets could, in the worst case, result in a credit crunch with painful consequences for the real economy Can we break the link between the illiquidity of banks’ securitized assets, which prevents their orderly liquidation, and the shortage of funding liquidity, which is the driving force of the negative feedback originating from the process of deleveraging? For funding liquidity, emergency liquidity support from central banks has helped lower the temperature in the worst moments, but it is not a long-term solution Setting a collateral value of illiquid securities does not provide a market for them and hence does not set a floor to their market prices; the collateralized securities remain on the intermediaries’ books, affecting the quality of their balance sheets Capital increases are also insufficient to break the spiral, as injections of capital may prove inadequate only a few weeks after their announcement For market liquidity, suggested remedies are equally inadequate Mandated full disclosure of losses might reduce uncertainty, but unless market liquidity is instantly restored, full disclosure of the situation at time t offers no guarantee that it will be the same at time t + Similarly, retreating from marking financial products to market or model during this time of crisis would face a number of difficulties More radical solutions The feedback between market and funding liquidity problems demands more radical pre-emptive solutions As long as ‘there is no immediate prospect that markets in mortgage-backed securities will operate normally’, ‘the situation will improve only if the overhang of illiquid assets on the banks’ balance sheets is dealt with’ (Bank of England, 2008) In creating its special liquidity scheme, the Bank of England has moved to serve as the market-maker of last resort The scheme allows banks and building societies to swap some of their illiquid assets, including debt securities rated no less than triple A, for specially issued Treasury bills for up to three years Eligible securities will be valued at market prices, if available, or, if not, at a price calculated by the Bank, with ‘haircuts’ for private debt securities Changes in market prices or in valuations will require remargining The credit risk will remain with the banks, so that there will be a loss for the lender only if the borrower defaults and the value of the collateral falls below that of the bills originally acquired in the operation Is the initiative bold enough? The scheme does not set a floor for assets’ market prices and uses market prices to value collateral, despite the fact that during a Avoiding disorderly deleveraging 181 negative bubble they not reflect fundamentals Downward instability may, moreover, occur if ‘haircut’ discounted collateral values trigger a convergence process for market prices requiring repeated re-margining In CEPR Policy Insight 22, I recommend the creation of a publicly sponsored entity that could issue guaranteed bonds to banks in exchange for illiquid assets, drawing on the US Treasury Secretary Nicholas Brady’s solution to the Latin American sovereign debt crisis in 1989 This new entity, preferably multilateral, would value assets based on discounted cashflows and default probabilities rather than crisis-condition market prices As a firm floor is set to valuation and illiquid assets otherwise running to waste are replaced by eminently liquid Brady-style bonds, funding difficulties and, at the same time, the market liquidity problems besetting the banks’ balance sheets would be removed Shielding the banks’ assets from the vagaries of disorderly markets is a necessary condition to dispel the uncertainty that prevents a proper working of credit markets Reference Bank of England (2008), ‘Special Liquidity Scheme’, Information, Market Notice, 21 April Chronology 28 December 2006 Ownit Mortgage Solutions files for bankruptcy February 2007 US Senate Banking Committee holds hearing on predatory lending in subprime sector 22 February 2007 HSBC losses top $10.5 billion Head of HSBC US mortgage-lending business is fired March 2007 The Federal Deposit Insurance Corporation issues a cease-and-desist order against subprime lender Fremont Investment & Loan, which had been ‘operating without adequate subprime mortgage loan underwriting criteria’ March 2007 Donald Tomnitz, the CEO of D R Horton, the largest US homebuilder, tells investors, ‘I don’t want to be too sophisticated here, but ‘07 is going to suck, all 12 months of the calendar year.’ 12 March 2007 Lenders to New Century Financial, a large subprime lender, cut off its credit lines Trading in its shares is suspended by the New York Stock Exchange 16 March 2007 Subprime lender Accredited Home Lenders to sell, at a heavy discount, $2.7 billion of loans The New York Attorney General announces an investigation of subprime lending April 2007 New Century Financial files for bankruptcy 24 April 2007 The National Association of Realtors announces that existing home sales fall 8.4% during March, the greatest drop in 18 years 183 184 The First Global Financial Crisis of the 21st Century May 2007 GMAC, the finance arm of General Motors, reports losses of $1 billion UBS closes its US subprime business First comprehensive plan to help homeowners avoid foreclosures presented in US Senate June 2007 The Bank of England reduces the overnight bank rate by 25 basis points to 5.5% 22 June 2007 Bear Stearns injects $3.2 billion into two of its hedge funds hurt by falling CDO prices July 2007 UK authorities take action against five brokers selling subprime mortgages 10 July 2007 All three major credit-ratings agencies announce review of subprime bonds 13 July 2007 General Electric to sell WMC Mortgage, its subprime lending business 18 July 2007 US housing starts down 20% from the previous year 31 July 2007 The two Bear Stearns hedge funds that were under stress file for bankruptcy protection August 2007 American Home Mortgage, one of the largest US home-loan providers, files for bankruptcy August 2007 BNP Paribas suspends three investment funds hit by subprime crisis An insurance company, AIG, warns that mortgage defaults are spreading beyond subprime sector 10 August 2007 The ECB provides €61 billion of funds for banks The Fed said it would provide as much overnight money The interest rate on 15-day AAA asset-backed commercial paper hits 6.14% for a historic high 13 August 2007 Goldman Sachs to pump $3 billion to rescue a hedge fund The ECB and central banks in the United States and Japan continue supplying liquidity to markets 16 August 2007 Countrywide draws down its $11.5 billion credit line Chronology 185 17 August 2007 The Federal Reserve cuts the discount rate to 5.75% 23 August 2007 Bank of America purchases 16% of Countrywide Financial for $2 billion Four large US banks announce coordinated borrowing of $2 billion from the Federal Reserve’s discount window 28 August 2007 German bank Sachsen Landesbank is sold to Landesbank Baden-Wuerttemberg The S&P/Case-Shiller Home Price Index for second quarter 2007 is down 3.2% from a year earlier, the greatest drop in the 17-year history of the index 31 August 2007 Subprime lender Ameriquest files for bankruptcy 1–3 September 2007 The Federal Reserve’s annual Jackson Hole conference focuses on the link between housing and monetary policy September 2007 IKB, a German regional lender, records $1 billion loss due to US subprime market exposure September 2007 Bank of China reveals $9 billion in subprime losses September 2007 The delinquency rate on 1–4 family mortgages reaches 5.1% in the US, according to the Mortgage Bankers Association 13 September 2007 Global Alpha, a hedge fund managed by Goldman Sachs, reveals that it lost 22% during August 14 September 2007 A run on the deposits of British mortgage lender Northern Rock begins 18 September 2007 The Federal Reserve cuts the discount rate by 50 basis points to 4.75% This is the first cut since 2003 October 2007 UBS and Citigroup announce losses of $3.4 billion and $3.1 billion respectively October 2007 The Dow Jones Industrial Average closes at 14,164, its all-time high 186 The First Global Financial Crisis of the 21st Century 10 October 2007 The US government teams up with mortgage servicers and investors to launch the HOPE NOW alliance, to encourage the voluntary modification of adjustable-rate mortgages to fixed-rate 14 October 2007 Citigroup, JPMorgan Chase and Bank of America, with the support of the Treasury Department, announce a plan to form a Master-Liquidity Enhancement Conduit (M-LEC) that would purchase asset-backed commercial paper from liquidation SIVs 15 October 2007 Citigroup and the Japanese bank Nomura announce subprime losses of $5.9 billion and $621 million, respectively 16 October 2007 The National Association of Home Builders confidence index hits 19, the lowest since the series began in 1985 26 October 2007 Countrywide Financial reports a loss of $1.2 billion for third-quarter 2007 This is its first loss in 25 years 30 October 2007 Merrill Lynch announces losses of $7.9 billion and the resignation of the CEO, Stan O’Neal 31 October 2007 The Federal Reserve cuts the federal funds rate by 25 basis points to 4.5% Deutsche Bank reveals a $2.2 billion loss November 2007 Credit Suisse discloses a $1 billion loss Fed injects $41 billion November 2007 Citigroup announces that its $55 billion portfolio of subprime-related investments has declined in value between $8 billion and $11 billion The CEO, Charles Prince, resigns November 2007 Morgan Stanley and BNP Paribas disclose mortgage losses of $3.7 billion and €197 million, respectively AIG writes down $2 billion of mortgage investments November 2007 Wachovia announces $1.7 billion loss 13 November 2007 Bank of America announces $3 billion subprime loss Chronology 187 14 November 2007 Japan’s second largest banking group, Mizuho, reports full-year operating profit fell 13% HSBC reports losses of $3.4 billion 15 November 2007 Barclays reveals $2.7 billion loss The US House of Representatives passes the Predatory Lending and Mortgage Protection Act 16 November 2007 Goldman Sachs forecasts financial losses due to subprime crises at $400 billion 19 November 2007 The reinsurance company, Swiss Re, to lose $1 billion on insurance of clients hit by subprime crises 20 November 2007 Freddie Mac reports a $2 billion loss 27 November 2007 Freddie Mac and Citigroup raise $6 billion and $7.5 billion of capital respectively US house prices record biggest quarterly drop in 21 years December 2007 The New York Attorney General sends subpoenas to major investment banks to investigate subprime mortgage securitization December 2007 Royal Bank of Scotland to write off £1.25 billion due to subprime crisis The Bank of England cuts UK interest rates 10 December 2007 UBS and Lloyds TSB report $10 billion and £200m losses due to bad debts in the US housing market 11 December 2007 The Federal Reserve lowers the federal funds rate by 25 basis points to 4.25% Washington Mutual subprime losses to reach $1.6 billion 12 December 2007 The Federal Reserve announces the creation of the term auction facility (TAF), which will auction a fixed amount of funds to the banking system, initially set at $20 billion The Federal Reserve, the ECB and the Swiss National Bank (SNB) also announce that they will engage in currency swaps of up to $20 billion to the ECB and $4 billion to the SNB The Bank of England and Bank of Canada also announce that they will increase their liquidity facilities 14 December 2007 Citigroup takes $49 billion worth of SIV assets back on its balance sheet 188 The First Global Financial Crisis of the 21st Century 17 December 2007 Federal Reserve makes $20 billion available to commercial banks 18 December 2007 The Federal Reserve Bank tightens rules on subprime lending The ECB lends European commercial banks $500 billion The Bank of England makes £10 billion available to UK banks 19 December 2007 As subprime losses reach $9.4 billion, Morgan Stanley sells 9.9% stake in the company 21 December 2007 The spread of 15-day AAA asset-backed commercial paper over equivalent duration AAA non-financial commercial paper hits 173 basis points as banks scramble for funding through the end of the year The spread is usually less than 10 basis points 22 December 2007 The M-LEC plan to rescue struggling SIVs is abandoned by the sponsoring banks January 2008 US job losses in residential construction and mortgage lending for the year 2007 estimated at 35,000 January 2008 Bear Stearns reveals subprime losses of $1.9 billion The CEO, James Cayne, steps down The World Bank says that world economic growth will slow in 2008 due to subprime crisis credit crunch 11 January 2008 Bank of America buys Countrywide for $4 billion after its shares plunge 48% Merrill Lynch doubles projection of subprime losses to $15 billion 15 January 2008 Citigroup reports a $9.8 billion loss for the fourth quarter, including $18 billion loss in mortgage portfolio 17 January 2008 Lehman Brothers retires from wholesale mortgage lending and will cut 1,300 jobs 19 January 2008 Fitch Ratings lowers the rating of Ambac, the second-largest monoline insurer after MBIA, from AAA to AA This is the first downgrade of a large monoline 22 January 2008 In a surprise move between regularly scheduled meetings, the Federal Reserve cuts the federal funds rate by 75 basis points to 3.50% Chronology 189 24 January 2008 The French bank Société Générale announces that it lost €4.9 billion due to the unauthorized activity of one of its traders While the bank closed out the trades during a holiday weekend in the United States, stockmarkets plunged round the world 30 January 2008 The Federal Reserve cuts the federal funds rate by 50 basis points to 3.00% Regularly scheduled auctions for municipal debt of the state of Nevada and Georgetown University fail due to lack of bidders and uncertainty about monoline insurers The debt issuers are forced to pay a penalty rate 13 February 2008 President Bush signs the Economic Stimulus Act of 2008 The Act provides approximately $100 billion of tax rebates to be distributed during summer 2008 and $50 billion of investment incentives 14 February 2008 UBS announces fourth-quarter 2007 loss of CHF12.4 billion ($12 billion) 15 February 2008 Problems in the auction-rate securities market continue to spread; over 1,000 auctions fail this week Investment banks not allow investors to withdraw funds invested in those securities 28 February 2008 AIG announces fourth-quarter 2007 losses of $5.3 billion due to more than $11 billion of losses on its credit-default swap portfolio March 2008 The delinquency rate on family mortgages was 5.82% during the fourth quarter of 2007, up 87 basis points from a year earlier, according to MBA’s National Delinquency Survey 11 March 2008 The Federal Reserve Bank of New York announces the creation of the term securities lending facility (TSLF), which lets primary dealers swap AAA-rated securities for Treasury securities The Federal Reserve, the ECB and SNB increase the size of their dollar swap lines to $30 billion and $6 billion respectively 14 March 2008 The investment firm, Carlyle Capital, defaults on $17 billion of debt The fund is leveraged more than 30:1 and invests mostly in agency-backed residential mortgage-backed securities (RMBS) 16 March 2008 The Federal Reserve Bank of New York announces the creation of the primary dealer credit facility (PDCF), which essentially opens the discount window to primary dealers, including non-depository institutions 190 The First Global Financial Crisis of the 21st Century 17 March 2008 The investment bank Bear Stearns is acquired by JPMorgan Chase for $2 per share Bear Stearns stock had been trading at $60 the previous week before a run pushed it to near insolvency The Federal Reserve Bank of New York agrees to guarantee $30 billion of Bear Stearns assets, mostly mortgage-related 18 March 2008 The Federal Reserve cuts the federal funds rate by 75 basis points to 2.25% 24 March 2008 JPMorgan Chase raises its bid for Bear Stearns to $10 per share and agrees to indemnify the Federal Reserve Bank of New York against the first $1 billion of losses on the $30 billion that it guaranteed April 2008 Washington Mutual, one of the largest US mortgage originators, raises $7 billion from TPG, a private equity firm The IMF’s Global Financial Stability estimates that the total credit losses will be $1 trillion 15 April 2008 Alpha magazine reports that hedge-fund owner John Paulson was the highest-paid trader in 2007 His fund, Paulson & Co., rose more than $20 billion in value during the year by shorting the mortgage market 18 April 2008 Citigroup announces another $12 billion of losses related to subprime mortgages, leveraged loans, exposure to monoline insurers, auction-rate securities and consumer credit 21 April 2008 National City Corporation, a large regional US bank, announces a $7 billion capital infusion from Corsair Capital, a private-equity firm 22 April 2008 Royal Bank of Scotland announces that it will raise about £16 billion from investors by selling assets 30 April 2008 The Federal Reserve lowers the federal funds rate by 25 basis points to 2.0% May 2008 UBS AG announces CHF11.5 billion ($11.1 billion) loss during first-quarter 2008 12 May 2008 Monoline insurer MBIA announces a $2.4 billion loss during first-quarter 2008 Glossary ABX.HE Index: an index produced by Markit that tracks prices on credit-default swaps on tranches of selected asset-backed securities composed of residential mortgages Alternative-A (or Alt-A): a category of mortgage borrower, generally with FICO (see below) scores that qualify them for prime rates but that are not eligible for prime for other reasons, such as lack of income documentation Asset-backed security (ABS): a security collateralized by financial assets, such as mortgages Asset-backed commercial paper (ABCP): see Commercial paper Auction-rate security: a municipal bond whose interest rate is set at specified intervals, often two weeks, at auction In early 2008 a large number of auctions failed due to lack of bidders, causing the municipalities to pay high penalty rates Basel II: a revision to the international rules governing bank capital allocation Coordinated by the Bank for International Settlements It was designed to lessen the amount of regulatory arbitrage that occurred under its predecessor, Basel I European banks were supposed to implement Basel II rules by 2008, while US banks implementation may occur in 2009 Commercial paper (CP): bonds with maturity of less than 270 days CP can be issued by corporations, banks or trusts holding securities The last is usually referred to as asset-backed commercial paper (ABCP) ABCP was one of the first casualties of the crisis, starting to decline rapidly in August 2007 as the SIVs unwound Collateralized debt obligation (CDO): a structured finance product composed of debt instruments such as corporate and consumer loans, mortgages and bonds The cash flows from the underlying debt are paid out to the tranches of the CDO according to their seniority CDO issuance averaged $500 billion in 2006 and 2007 Conduit: a financial entity whose purpose is to buy financial assets from correspondents, repackage them and sell interests in the new securities to other entities 191 192 The First Global Financial Crisis of the 21st Century Credit-default swap (CDS): a type of insurance against a firm defaulting on its debt According to the Bank for International Settlements, the notional amount of CDS outstanding was $43 trillion as of June 2007 Discount window: the mechanism through which the Federal Reserve lends directly to banks, thrifts and other chartered depository institutions The PDCF essentially extended the discount window to primary dealers Fannie Mae/Freddie Mac: US government-sponsored enterprises (GSEs) that enhance the flow of credit to the mortgage market The GSEs purchase mortgages from banks and thrifts and either keep the mortgages or package them into RMBS (see below) and sell them to the secondary market FICO score: a numerical rating of the credit history of individuals, developed by the Fair Isaac Corporation LIBOR: London interbank offered rate, the interest rate that banks charge each other to borrow money Denominated in various currencies US dollar LIBOR is usually tied closely to the federal funds rate but diverged beginning in August 2007 due to a combination of credit and liquidity risk Monoline insurer: An insurance company that specializes in insuring the performance of financial instruments, usually mortgage-related Most offer private mortgage insurance, which is used to insure payments on mortgages with high loan-to-value ratios Many also insure AAA-rated portions of CDOs Mortgage-backed security (MBS): a security that is composed of mortgages Often separated into MBS backed by residential mortgages (RMBS) and commercial mortgages (CMBS) Fannie Mae and Freddie Mac dominated MBS issuance in the United States until 2004 when private-label MBS, often of subprime mortgages, became more prevalent Payments of interest and principal on the underlying mortgages can be paid pro-rata (pass-through MBS) or in a ‘waterfall’ fashion, with ‘tranches’ getting paid in order of seniority Primary dealer credit facility (PDCF): A new policy introduced by the Federal Reserve that essentially opens the discount window to primary dealers Normally only banks and other depository institutions have access to the discount window The PDCF was introduced by the Federal Reserve the same weekend that Bear Stearns was acquired by JPMorgan Chase Residential mortgage-backed security (RMBS): see Mortgage-backed security Securitization: the practice of bundling securities into new securities Used by financial institutions as a way of moving assets off their balance sheets in order to lend more Mortgages are most commonly securitized but other debt instruments can also be included In the United States, Fannie Mae and Freddie Mac actively promote mortgage securitization Glossary 193 Structured investment vehicle (SIV): a fund that holds long-term securities (such as mortgages) and funds its investments with commercial paper Subprime: borrowers whose poor credit history does not qualify them for prime interest rates In the United States, about 20% of mortgage originations totalling over $1 trillion in 2005 and 2006 were subprime, far above historical levels Term auction facility (TAF): an auction held by the Federal Reserve for a set quantity of money The TAF was introduced in December 2007 in response to pressures for short-term lending in the money markets Term securities lending facility (TSLF): The TSLF is an arrangement by the Federal Reserve to lend to Treasuries and accept other AAA-rated financial instruments as collateral Tranche: a method of apportioning cashflows in a structured finance product, such as an asset-backed security Senior tranches are paid principal and interest first, and junior tranches are paid with whatever cash is left Senior tranches have more security and consequently earn lower interest rates than junior tranches Several tranches may be rated AAA The most senior of the AAA tranches is often called ‘super-senior’ ... directly blaming the Federal Reserve for the crisis but present empirical evidence that low The First Global Financial Crisis of the 21st Century interest rates, like those present in the United States... those particular losses 17 18 The First Global Financial Crisis of the 21st Century Here comes the securitization story, and it is not controversial either The dilution of risk is a good thing, no... now, while the fear of the current crisis is fresh and not when the crisis is over and the seat belts are working again Avinash Persaud (200 0), ‘Sending the Herd off the Cliff Edge: the Disturbing